ESMA warns of growing links between crypto and finance

The links between crypto and traditional finance are becoming important enough to attract more attention from the European regulator. In its risk monitoring report published on September 10, ESMA asks to closely monitor this interconnection. Tokenized stocks, DeFi and predictive markets are directly mentioned. The regulator is not yet talking about an established systemic risk, but about new channels capable of transmitting a crypto shock to the rest of the financial markets.

Crypto and traditional finance are becoming less and less separated

The formula used by ESMA is quite clear. The regulator is calling for increased monitoring of the growing link between crypto markets that it considers “increasingly vulnerable” and the broader financial system.

Tokenized shares are one of the examples chosen. Their weight still remains negligible compared to global equity markets. Their adoption is nevertheless progressing and brings new infrastructures, new investors and new intermediaries into the same circuit.

We had already detailed ESMA’s reservations regarding tokenized actions, particularly when the token does not give exactly the same rights as the traditional action that it represents.

The change in tone is interesting. In March, ESMA still wrote that adoption of tokenization remains limited, with relatively low volumes and narrow applications. She already recognized progression and possible advantages: faster settlement, automation by smart contracts or use of traditional assets in DeFi.

Six months later, adoption remains early. But the subject now also appears in the section of financial transmission risks. The border is moving.

DeFi exploits can now go beyond just crypto

DeFi constitutes the second point. ESMA cites recent protocol exploits as a renewed source of concern regarding interconnection and possible spillover effects. It does not give, in its press release, a precise list of the incidents responsible for this concern.

The mechanism is quite simple. As long as a DeFi protocol only handles purely crypto assets, a loss remains mostly concentrated in this ecosystem. Things change when the same protocols accommodate tokenized stocks, money market funds, private credit or other assets from traditional finance.

A compromised smart contract can then affect assets whose value and counterparties are located outside the blockchain.

This is precisely the rapprochement that ESMA monitors. The subject goes beyond Europe. The OECD has identified this year the growth of connections between crypto and traditional markets as a potential risk of contagion, particularly via stablecoins and their reserves of classic financial assets.

This does not mean that a DeFi attack today would cause a European financial crisis. ESMA does not affirm this. Rather, it says that the more the two systems use the same assets and the same actors, the more difficult it becomes to consider their risks separately.

Tokenization accelerates this convergence. Tremplin.io recently noted that tokenization is becoming a major project for financial institutions.

Predictive markets add another problem

The third file is less linked to credit or liquidity risk. It concerns market integrity. According to ESMApredictive markets may present increased risks of insider trading, wash trading and coordinated manipulation. The use of crypto infrastructures can also make it more difficult to detect some of these practices.

The regulator had already started to take an interest in it before this new report. In July, he recalled that certain contracts based on a binary outcome may fall under existing European rules on binary options. It all depends on the product and the underlying event. Certain contracts may also fall under national gaming law.

We then explained how ESMA supervises predictive markets in Europe. However, the sector continued to grow. The platforms now make it possible to take a position on elections, economic decisions, sporting events or legal texts. For ESMA, the problem is therefore no longer just whether a token falls under MiCA or whether a DeFi protocol operates without an intermediary. Crypto is starting to share more assets, liquidity and users with traditional finance. For now, ESMA is talking about surveillance and vulnerabilities, not an ongoing crisis.